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Tomorrow the FOMC will embark upon its new communications
strategy, by which it will release information on the
interest-rate path, consistent with achieving its dual mandate of
low inflation and low unemployment. As always, the devil is
in the details; and we will explore some of the gotchas that may
result, depending upon which of the many possible scenarios they
choose. But first, it is important to correct a
misperception being perpetuated in the press when they state that
the FOMC will reveal its interest-rate “forecast(s).” Since
the FOMC sets the short-term Federal Funds target, its inflation,
unemployment, and GDP forecasts are conditional upon the path its
sets or that is assumed. The FOMC is not “forecasting” the
Federal Funds rate. Each committee participant is
instructed to assume the path consistent with the committee’s
longer-run objectives and then provide forecasts of GDP,
inflation, and unemployment.

So what are the possible options as to how the FOMC might choose
to release the interest-rate information? The options
entail two different dimensions, involving the amount of detail
provided and the frequency of the data released (i.e., quarterly,
annually, etc.).

In terms of detail, the committee might choose to provide a
consensus path, the individual paths assumed by each participant,
and/or a fan chart, similar to those released by other central
banks, like the Riksbank of Sweden. The Riksbank provides
the mean path and probability ranges around that path. The
analogy for the FOMC would be to provide the central tendency of
the path and range, similarly to what it does now for GDP,
inflation, and unemployment.

But right now, the FOMC only provides yearly forecasts for both
GDP and inflation while unemployment rate is the rate expected to
prevail at the end of the year. If the frequency of those
releases doesn’t change, then the FOMC could choose to provide
the Funds rate assumed to be in place at the end of the forecast
year, or it could provide the average over the year.
Neither one of these is likely to be particularly informative,
nor would it avoid creating confusion in the market. For
example, the FOMC embarked upon a slow and steady path of
increasing the Funds rate by 25 basis points for 18 consecutive
meetings beginning in June 2003. If in June the FOMC had
provided data to the market suggesting that the Funds rate would
be 125 basis points higher at year end and would at that same
time be 325 basis points higher by the end of 2004 and 425 basis
points higher by the end of 2006, it is likely that the
performance of the economy and path for market rates would have
been substantially different from what they turned out to
be. Clearly, if the market had been appraised of the likely
path for policy, all the smart money would have shortened
durations, the term structure would have flattened, and
short-term rates would have risen more than long-term rates,
which likely would have moved up sharply as well. The shock
to markets would have been huge. Now, it isn’t likely that
the FOMC would have had perfect foresight, as most of the models
it employs assume about both market participants and policy
makers, with respect to the path that was subsequently followed,
so periodic changes would have surprised markets. The end
result would have been more volatility and uncertainty rather
than useful information.

Two other points are critical. First, there would have been
lots of different ways to get to a 125-basis-point increase in
rates by year-end 2004, and as far as market participants are
concerned the path is critical. For example, if markets had
known that rates would move by only 25 basis points per meeting,
they likely would have responded much differently than if rates
had simply moved up in different increments and at meetings than
at others. Another source of uncertainty is likely to be
introduced by the new policy, related to its conditional
nature. President Plosser, for example, has continually
emphasized that the future path for the Federal Funds rate is
conditional on realization of GDP, inflation, and unemployment
levels. Intermeeting upside or downside surprises, for
example, might require a revision in the assumed path for rates,
which might then call for either a deviation from the short-term
path previously identified or an adjustment in the longer-term
path with no change in the short-term policy. In this case the
logical question for market participants to ponder is how much of
a short-term deviation from the expected paths for inflation,
unemployment, and/or GDP would be sufficient to cause the FOMC to
revise policy and the policy path it assumed.

The less frequent the forecast revisions and the less detail
provided about the intermeeting forecasts for the key variables
of interest, the more uncertainty that is likely to
prevail. Since the FOMC does meet eight times a year, and
twice within each quarter, it would seem logical to provide at
least quarterly forecasts for the key variables, rather than
simply annualized data. Changing both the frequency of the
forecasts and when they are provided would suggest that they
should be updated at each FOMC meeting and released, with
quarterly annualized estimates to match how GDP data are
provided.

There has been the suggestion that the paths assumed by each
participant might be released. There are three issues
here. First, since only five reserve bank presidents vote,
along with the current five governors (normally seven), it
becomes critical to know, not the average path or the range of
possible paths, but rather the paths of those actually
voting. Clearly, given the present make-up of the
committee, not all would have the same set of policy assumptions
nor the same reactions to deviations of key variables from the
forecasts. If individual forecasts are provided, then it is
also important to be able to identify the assumed rate path with
the projections for GDP, inflation, and employment. Without
that information, knowing the rate path is of little use.

One could go on and on and spin different scenarios and cite
problems with the alternative disclosures the FOMC is about to
make. Whether the information provided will be useful or
not, and whether it will reduce or add to uncertainty, remains to
be seen. One thing is for certain: Chairman Greenspan was
always very cautious about changing how policy was revealed or
modifying the FOMC’s communications; because he emphasized that,
once done, the change could never be undone, so it had better be
right.